MICROECONOMICS: Theory & Applications Chapter 13: Monopolistic Competition and Oligopoly By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College

Learning Objectives Explain how price and output are determined under monopolistic competition. Understand the characteristics of oligopoly. Explore several key non-cooperative oligopoly models: Cournot, Stackelberg, and dominant firm. Show how price and output are determined under the cooperative oligopoly model of cartels. Copyright 2012 John Wiley & Sons, Inc.

Price and Output Under Monopolistic Competition Monopolistic competition – a market characterized by: unrestricted entry and exit a large number of independent sellers producing differentiated products Differentiated product – a product that consumers view as different from other similar products. Copyright 2012 John Wiley & Sons, Inc.

Determination of Market Equilibrium The demand curve facing each firm is downward-sloping but fairly elastic, reflecting a firm’s market power. Differs from a monopoly: Firm demand curve is not the market demand. Entry into the market is not restricted. Firms compete on product differentiation as well as price. Long-run equilibrium: attained as a result of firms entering (or leaving) the industry in response to profit incentives. Price > MC zero economic profit Copyright 2012 John Wiley & Sons, Inc.

Figure 13.1 - Determination of Market Equilibrium Copyright 2012 John Wiley & Sons, Inc.

Monopolistic Competition and Efficiency Excess capacity – the result of firms failing to produce at lowest possible average cost The firm does not operate at the minimum point on the LR average cost curve. Total output is wrong from a social perspective due to deadweight loss Deadweight loss is analytically reduced if the interdependence between individual firms’ demand is taken into account Copyright 2012 John Wiley & Sons, Inc.

Figure 13-2 – Alleged Deadweight Loss of Monopolistic Competition Copyright 2012 John Wiley & Sons, Inc.

Is Government Intervention Warranted? 3 reasons why government intervention is probably not warranted: Any deadweight loss is likely to be small, due to the presence of competing firms and free entry. Any possible inefficiency cost must be weighed against the product variety produced and the benefits of such variety to consumers. The costs of intervention must be balanced against the potential gain from expanding output. Copyright 2012 John Wiley & Sons, Inc.

Oligopoly Oligopoly – an industry structure characterized by: a few firms producing all or most of the output of some good that may or many not be differentiated mutual interdependence: a firm’s actions have an effect on its rivals and induce a react by the rivals barriers to entry which can influence pricing behavior many theoretical models Copyright 2012 John Wiley & Sons, Inc.

The Cournot Model Duopoly – an industry with two firms Cournot Model – a model of oligopoly that assumes each firm determines its output based on the assumption that any other firms will not change their outputs. Equilibrium is reached when neither firm has any incentive to change output Copyright 2012 John Wiley & Sons, Inc.

Figure 13.3 - The Cournot Model Copyright 2012 John Wiley & Sons, Inc.

Reaction Curves Reaction Curve – a relationship showing one firm’s most profitable output as a function of the output chosen by other firms Cournot equilibrium occurs at the intersection of two reaction curves: Total output is usually between that of pure monopoly and competition. Price exceeds MC. Price exceeds AC => economic profit > 0 Collusion can increase combined profits of firms. Copyright 2012 John Wiley & Sons, Inc.

Figure 13.4 – The Cournot Model with Reaction Curves Copyright 2012 John Wiley & Sons, Inc.

Evaluation of the Cournot Model The assumption that each firm takes the output of a rival firm as constant is implausible if the market is adjusting toward equilibrium. However, if equilibrium is established, firms will not see the assumption invalidated. the assumption is more plausible the larger the number of firms in the market. Copyright 2012 John Wiley & Sons, Inc.

Other Oligopoly Models The Stackelberg Model – a model of oligopoly in which a leader firm selects its output first, taking the reactions of follower firms into account Dominant Firm Model – a model of oligopoly in which the leader or dominant firm assumes its rivals behave like competitive firms in determining their output Copyright 2012 John Wiley & Sons, Inc.

The Stackelberg Model Residual demand curve – a firm’s demand curve based on the assumption that the firm knows how much output rivals will produce for each output the firm may choose Key point: a firm’s conjectures in an oligopoly about how rivals will respond can affect firms’ outputs, profits, and total industry output. Which model is better? It depends upon the particular market under examination Copyright 2012 John Wiley & Sons, Inc.

Figure 13.5 - The Stackelberg Model Copyright 2012 John Wiley & Sons, Inc.

The Dominant Firm Model The leader assumes its rivals behave like competitive firms in determining their output. Also known as “the dominant firm with a competitive fringe” model. At any price, the dominant firm can sell an amount equal to the total quantity demanded at that price minus the quantity the fringe firms produce. At equilibrium, price > MC for the dominant firm but price = MC for the fringe firm Total output < output for a competitive industry Model is applicable if there are many fringe firms. Copyright 2012 John Wiley & Sons, Inc.

Figure 13. 6 - The Dominant Firm Model Copyright 2012 John Wiley & Sons, Inc.

The Elasticity of the Dominant Firm’s Demand Curve ηD = ηM (1/MS) + εSF((1/MS) – 1) where: ηD = elasticity of the dominant firm’s demand ηM = elasticity of the market demand MS = the dominant firm’s market share εSF = elasticity of supply of the fringe firms (continued) Copyright 2012 John Wiley & Sons, Inc.

The Elasticity of the Dominant Firm’s Demand Curve (continued) Copyright 2012 John Wiley & Sons, Inc.

Cartels and Collusion Cartel – an agreement among independent producers to coordinate their decisions so each of them will earn monopoly profit Collusion – coordinated decisions among independent producers in an industry Cartels are illegal under antitrust laws in the United States. Copyright 2012 John Wiley & Sons, Inc.

Figure 13.7 – A Cartel Copyright 2012 John Wiley & Sons, Inc.

Why Cartels Fail Each firm has a strong incentive to cheat on the cartel agreement. Members of the cartel will disagree over appropriate cartel policy regarding pricing, output, allowable market shares, and profit sharing. Profits of the cartel members will encourage entry into the industry. Copyright 2012 John Wiley & Sons, Inc.

Oligopolies and Collusion Firms in an oligopolistic industry can increase their profits by colluding. The limited number of firms makes it easier to reach agreements. When few firms are involved, it is easier to detect cheaters. Factors that inhibit the formation and maintenance of cartels: Incentive to cheat Higher price achieved by collusion prompts entry by new firms It is not necessary for all firms in the industry to participate in the cartel for it to be worthwhile. Copyright 2012 John Wiley & Sons, Inc.

The Case of OPEC Reasons for Success: The price elasticity of demand for oil is low in the short run. The price elasticity of supply of oil from non-OPEC suppliers is low in the short run. Oil-importing nations frequently adopted policies that strengthened OPEC’s position. In general, the magnitude of any response in consumption and production will be greater the more time consumers and producers are given to respond. Copyright 2012 John Wiley & Sons, Inc.

Figure 13.8 – OPEC Cartel as a Dominant Firm Copyright 2012 John Wiley & Sons, Inc.

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